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Most ETFs Are Tax-Smart. But Others...

Here's how exchange-traded funds can help investors hold off Uncle Sam—or can trip them up

By

Ari I. Weinberg

January 9, 2012

Exchange-traded funds are hardly the magic models of tax efficiency that some advisers or fund sponsors would like investors to believe. But generally, they are at least as good at minimizing tax pain for stock investors as index funds, the most tax-efficient type of mutual fund.

Here's a closer look at the tax advantages of ETFs and the limits of those benefits, particularly when investing in assets other than stocks.

How does ETF structure affect taxes?

The vast majority of ETFs are regulated as traditional mutual funds under the Investment Company Act of 1940, and most are similar to conventional index funds in that they buy and hold the components of a market benchmark. The difference is that unlike their mutual-fund cousins, ETFs trade like stocks. As long as the indexes they are tracking don't see big changes in their components, ETFs, like index funds, rarely have to make portfolio changes.

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Avoiding such changes helps limit realized capital gains that might have to be distributed to investors.

But there is a significant difference in how ETFs operate compared with mutual funds that also helps with tax efficiency. When a traditional mutual fund receives cash from investors, it issues fund shares and buys a representative set of its portfolio investments. When investors redeem, the fund delivers cash and may have to sell underlying investments, which can result in capital gains that are subject to tax.

David Plunkert

With ETFs, ordinary investors buy and sell ETF shares from other investors, not from the fund itself. Meanwhile, ETF shares are created and redeemed in so-called in-kind transactions with big institutional investors: To receive ETF shares, market makers, known as authorized participants, deliver the underlying securities (or a representative basket) to the fund manager. And when they redeem ETF shares, they are handed securities rather than cash, which often eliminates the need for the fund to take gains.

What's the impact of ordinary investors' buying shares from each other?

With this design, buying and selling by one investor doesn't result in tax consequences for the rest of the fund because the ETF doesn't have to sell securities to pay off departing investors. ETFs allow investors to be "isolated from the actions of other investors," says
Ryan Issakainen,
ETF strategist for ETF sponsor First Trust Advisors LP. And, because the cost of trading is borne by the individual investor, securities-transaction costs for the fund itself are low.

How do in-kind transactions affect a fund's tax efficiency?

They allow ETF managers to make tax-wise decisions about which securities to distribute and whether to sell securities or distribute them in-kind.

In industry parlance, ETFs can internalize losses and externalize gains. That is, when an index change requires an ETF to get rid of a stock that has fallen in price since purchase, the fund can make the sale on the open market, collect the cash and take the capital loss on its books. If the fund is looking at a winning trade, the bias is to pass that stock out in an in-kind redemption—taking its low cost basis out with it, as well as any potential capital-gains tax bill.

Most stock and even bond ETFs are based on indexes with relatively low turnover. For indexes that require more frequent rebalancing or reconstitution, the ETF and authorized participants have a more significant operational challenge for managing taxes. Still, even funds that make a lot of changes in their composition tend not to pay out a lot of taxable gains.

Are all ETFs very tax-efficient?

No. While many ETFs are tax-efficient in limiting gains payouts, thereby delaying tax consequences until investors sell their ETF shares, that's only one part of the picture. If an ETF or a mutual fund distributes income from taxable bond interest, for example, that income will be taxable at ordinary-income rates. The tax treatment is based on the underlying investments.

And some ETFs invest in holdings whose tax treatment may dismay investors. ETFs that invest in commodities-futures contracts are prime examples. These are regulated as commodity pools, and gains or losses realized by the funds are taxable events even without any distributions being paid to shareholders; 60% is subject to the long-term gains rate and 40% to the short-term rate. Gains on ETFs that hold gold, silver or other precious metals are taxed at the collectibles rate of 28%.

A further tax headache: Some of these non-stock ETFs send investors their tax information on Schedule K-1 rather than the common 1099 form. The more complex form can saddle investors with extra work or higher bills for tax preparation.